The pitfalls of official first-loss bond insurance

by Daniel Gros

Vox
October 2011

At 4am today, EZ leaders agreed the rough outline of a package of measures designed to end the EZ crisis. This column argues that a central pillar of the package will not work. The so-called first-loss insurance of EZ sovereign debt relies on an incomplete analysis of the underlying problem and the proposed solution.

Imagine you own a house next to a nuclear reactor and you’re offered insurance. The contract compensates you for the first 20% of your losses if the reactor melts down. Would you sleep much better with such insurance?

For financial markets, Italy is a lot like Fukushima. Everything works fine and the insurance is useless, or a disaster strikes and it’s nowhere near enough. Any state of the world where Italy restructures by 20% is a situation akin to Fukushima. In short, this sort of ‘first-loss’ insurance is not very likely to make much of an impression to clearheaded bond-buyers when it comes to Italian or Spanish bonds.

The official reasoning behind this approach of offering a ‘first-loss’ insurance was quite simple. Perhaps it was too simple.

• Since the debt burden of Italy (as well as that of Spain) appears manageable, investors should expect only a modest loss in case of default.
• If the expected loss in case of default were only 20%, a ‘first-loss’ guarantee should actually make the bonds riskless (implying a large fall in interest rates for Italy and Spain).

However, this reasoning overlooks the hard facts. Sovereign default is a very rare event, but when it does occur, it’s big – like a tsunami flooding a nuclear reactor. ‘First-loss’ insurance cannot make Italian bonds riskless.

Investors might reason that once the EFSF has issued large amounts of the first-loss guarantee it will become even more reluctant to let Italy default because this would lead to large losses for itself. The first-loss insurance can thus be understood as a partial Eurobond. It lowers the probability of a formal default.

In this way, the first-loss guarantee might lower the probability of an unlikely event, but it might increase the losses in case it eventually arrives. After all, Greece (and many other cases) show that if insolvency is not recognised early, the cost of the eventual default increases. With a lower probability of a bigger loss, the net effect on bond prices could go either way.

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